Investing basics: why investors go gaga over interest rates
An understanding of how interest rates work is crucial as they can affect whether you get a good savings rate from your bank or solid returns from the stock market.
Tuesday 7 May was marked by many as the day Meghan Markle and Prince Harry announced the arrival of "baby Sussex" to the world.
Others bemoaned the arrival of a sweeping UN report that found that species of all kinds are disappearing because of human activity.
And who could forget that egg narrowly missing the head of Prime Minister Scott Morrison.
But away from Buckingham Palace and the Australian election campaign, 7 May marked the most highly anticipated Reserve Bank of Australia meeting in 2½ years.
For weeks, economists were split on whether the RBA would cut the cash rate from its historically low rate of 1.5 per cent.
One the one hand, some economists pointed to last month zero level of inflation as a catalyst for a cut. Housing too has been a key argument from those in favour of a cut in rates.
Others tipped the RBA would hold, preferring to wait for a sustained increase in the unemployment rate before cutting.
Then at 2.30pm on the dot, an announcement was made:
"At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent."
For the 33rd consecutive month, the RBA resisted the temptation to cut the cash rate.
Despite the anticlimax, it was nevertheless a key moment because rates matter, a lot. They can affect whether you get hired for a new job or get a good savings rate from your bank.
And if you're an investor, a change in rates can either ignite the economy, or restrain it, which in turn affects your returns.
We spoke to Eleanor Creagh (pictured), Australian markets strategist with Saxo Bank, to get a no-nonsense explainer on how an understanding of interest rates can help investors make better financial decisions.
What are interest rates?
Interest rates are the cost of borrowing money. If you're a borrower, interest rates are the fees you're charged by the lender for using their money.
For example, let's say you want to borrow $1000 from the bank to buy a new smartphone.
The bank says sure, but charges you a 5 per cent interest rate. When you pay back the loan, you must also pay the interest: 5 per cent of $1000 – or $50. Therefore, your total repayments are $1050.
Simple. But that's not where things stop.
How does a bank determine how much interest to charge borrowers? The cash rate set by the RBA on the Tuesday of every month influences how Australian banks set their rates.
As the RBA puts it, the cash rate is the "rate charged on overnight loans between financial intermediaries". Banks are not required to adhere to the cash rate, but the RBA rate has "a powerful influence on other interest rates" and "forms the base on which the structure of interest rates in the economy is built".
For the purpose of this piece, we're focusing on the rate set by the RBA, not the rate set by an individual bank. The RBA cash rate affects Australia's money supply – in short, the amount of money in circulation – and therefore the state of the economy.
In Australia, the cash rate has been at 1.5 per cent for 33 months. Rates have been low since the 2008 global financial crisis as central banks try to stimulate consumer spending and growth.
Graph of the Cash Rate
Source: RBA
How do changes in interest rates affect the economy?
The RBA cash rate has a big influence on the state of the economy, and in turn, the stock market.
As Creagh explains, when interest rates increase, economies usually see a decrease in aggregate demand – or the total demand for goods and services in the economy - and that usually leads people to spend less.
Why? Because high interest rates make loans more expensive. When the cost of borrowing increases, fewer people and businesses are able to borrow money. There is also an incentive for people to save as they can get a higher savings rate from the bank. When there is less credit available to borrowers, demand falls.
These adjustments take time to affect the economy. Consequently, the supply side doesn't respond as quickly as the demand side of the economy. A gap thus occurs where you have a supply glut – e.g. excess workers, infrastructure, goods, inventory, etc.
"So, in that case that flows through to a downward pressure on prices, workers wages, on good within the economy, and ultimately inflation," Creagh says.
On the flip side, when interest rates decrease, economies usually see an increase in aggregate demand because people feel they can afford to borrow and therefore spend.
Conversely, people have less incentive to save because the returns on deposits are lower. As a result, in a low interest climate, savers might put their money into riskier investments such as stocks in a bid to get higher returns.
Similarly, Creagh says a lag is formed when the supply side doesn't respond as quickly as the demand side.
"There's going to be a period of time where the demand for extra work within the economy, extra goods, infrastructure spending etc will actually exceed that which is suppled," she says.
The cash rate, set by the RBA, influences how Australian banks set their rates
"In this scenario, you get a drawdown in inventory, things are pushed more quickly to meet that excess demand, and you get upward pressure on prices, and flow through to increased inflationary pressures throughout the economy."
Determining how long it takes for a rate change to flow through to the stock market is tricky. Creagh estimates it can be nine months for the transition effects to fully materialise in the economy.
Don’t forget currency movements
Investors who invest money overseas should also pay attention to currency rates. Currency fluctuations may move against you, causing you to lose money.
A lower cash rate may stimulate economic growth, but it can also lower the value of the Australian dollar. This is because when the cash rate is low, lending the Australian dollar with a low return becomes less attractive, and demand for the dollar falls.
Creagh adds the Australian dollar is a crucial tool for the RBA.
"The lower Australian dollar will not only provide stimulus through to the external sector, but also stimulate demand for good within the domestic economy that are priced in Australian dollars," she says.
"We might not like a lower Australian dollar because potentially it means we can't buy as many goods from overseas, or maybe our overseas holiday becomes a little bit more expensive. But it's a very respected tool in stabilising economic growth with Australia because it can cause us to alter our savings habits.
"You're also going to be more inclined to spend those Australian dollars within the economy. Maybe you won't go on a Greek holiday this summer, maybe you'll go to the Gold Coast. And that has a stimulatory effect within the Australian economy. "
